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This paper argues that the introduction of the Banking Recovery and Resolution Directive (BRRD) improved market discipline in the European bank market for unsecured debt. The different impact of the BRRD on bank bonds provides a quasi-natural experiment that allows to study the effect of the BRRD within banks using a difference-in-difference approach. Identification is based on the fact that (otherwise identical) bonds of a given bank maturing before 2016 are explicitly protected from BRRD bail-in. The empirical results are consistent with the hypothesis that debt holders actively monitor banks and that the BRRD diminished bail-out expectations. Bank bonds subject to BRRD bail-in carry a 10 basis points bail-in premium in terms of the yield spread. While there is some evidence that the bail-in premium is more pronounced for non-GSIB banks and banks domiciled in peripheral European countries, weak capitalization is the main driver.
Coordination of circuit breakers? Volume migration and volatility spillover in fragmented markets
(2018)
We study circuit breakers in a fragmented, multi-market environment and investigate whether a coordination of circuit breakers is necessary to ensure their effectiveness. In doing so, we analyze 2,337 volatility interruptions on Deutsche Boerse and research whether a volume migration and an accompanying volatility spillover to alternative venues that continue trading can be observed. Different to prevailing theoretical rationale, trading volume on alternative venues significantly decreases during circuit breakers on the main market and we do not find any evidence for volatility spillover. Moreover, we show that the market share of the main market increases sharply during a circuit breaker. Surprisingly, this is amplified with increasing levels of fragmentation. We identify high-frequency trading as a major reason for the vanishing trading activity on the alternative venues and give empirical evidence that a coordination of circuit breakers is not essential for their effectiveness as long as market participants shift to the dominant venue during market stress.
We examine whether the economy can be insured against banking crises with deposit and loan contracts contingent on macroeconomic shocks. We study banking competition and show that the private sector insures the banking system through such contracts, and banking crises are avoided, provided that failed banks are not bailed out. When risks are large, banks may shift part of them to depositors. In contrast, when banks are bailed out by the next generation, depositors receive non-contingent contracts with high interest rates, while entrepreneurs obtain loan contracts that demand high repayment in good times and low repayment in bad times. As a result, the present generation overinvests, and banks generate large macroeconomic risks for future generations, even if the underlying productivity risk is small or zero. We conclude that a joint policy package of orderly default procedures and contingent contracts is a promising way to reduce the threat of a fragile banking system.
We investigate whether and how the shift from discretionary forward-looking provisioning to the restrictive incurred loss approach under International Financial Reporting Standards (IFRS) in the European Union (EU) affects the cross-country comparability and predictive ability of loan loss allowances. Given bank supervisors’ keen interest in comparable and adequate loan loss allowances, we also examine the role of supervisors in determining financial statement effects around IFRS adoption. We find that the application of the incurred loss approach has led to more comparable loan loss allowances. However, some differences persist in countries where supervisors were reluctant to enforce the incurred loss approach. Our results also suggest that the predictive ability of loan loss allowances improved following IFRS adoption. Finally, in supplemental analyses we document that increased comparability of loan loss allowances is associated with the cross-country convergence of the risk sensitivity of bank leverage indicating an improvement in the effectiveness of market discipline in the EU.
This paper investigates the roles psychological biases play in empirically estimated deviations between subjective survival beliefs (SSBs) and objective survival probabilities (OSPs). We model deviations between SSBs and OSPs through age-dependent inverse S-shaped probability weighting functions (PWFs), as documented in experimental prospect theory. Our estimates suggest that the implied measures for cognitive weakness, likelihood insensitivity, and those for motivational biases, relative pessimism, increase with age. We document that direct measures of cognitive weakness and motivational attitudes share these trends. Our regression analyses confirm that these factors play strong quantitative roles in the formation of subjective survival beliefs. In particular, cognitive weakness is an increasingly important contributor to the overestimation of survival chances in old age.
We use minutes from 17,000 financial advisory sessions and corresponding client portfolio data to study how active client involvement affects advisor recommendations and portfolio outcomes. We find that advisors confronted with acquiescent clients stick to their standards and recommend expensive but well diversified mutual fund portfolios. However, if clients take an active role in the meetings, advisors deviate markedly from their standards, resulting in poorer portfolio diversification and lower Sharpe ratios. Our findings that advisors cater to client requests parallel the phenomenon of doctors prescribing antibiotics to insistent patients even if inappropriate, and imply that pandering diminishes the quality of advice.
We show that bond purchases undertaken in the context of quantitative easing efforts by the European Central Bank created a large mispricing between the market for German and Italian government bonds and their respective futures contracts. On top of the direct effect the buying pressure exerted on bond prices, we show three indirect effects through which the scarcity of bonds, resulting from the asset purchases, drove a wedge between the futures contracts and the underlying bonds: the deterioration of bond market liquidity, the increased bond specialness on the repurchase agreement market, and the greater uncertainty about bond availability as collateral.
We establish that the labor market helps discipline asset managers via the impact of fund liquidations on their careers. Using hand-collected data on 1,948 professionals, we find that top managers working for funds liquidated after persistently poor relative performance suffer demotion coupled with a significant loss in imputed compensation. Scarring effects are absent when liquidations are preceded by normal relative performance or involve mid-level employees. Seen through the lens of a model with moral hazard and adverse selection, these results can be ascribed to reputation loss rather than bad luck. The findings suggest that performance-induced liquidations supplement compensation-based incentives.
This paper presents new evidence on the expectation formation process from a Dutch household survey. Households become too optimistic about their future income after their income has improved, consistent with the over-extrapolation of their experience. We show that this effect of experience is persistent and that households over-extrapolate income losses more than income gains. Furthermore, older households over-extrapolate more, suggesting that they did not learn over time to form more accurate expectations. Finally, we study the relationship between expectation errors and consumption. We find that more over-optimistic households intend to consume more and subsequently report higher consumption, even though they do not consume as much as they intended to. These results suggests that overextrapolation hurts consumers and amplify business cycles.